585 / 708
The Independent Adviser for Vanguard Investors
•
April 2016
•
7
FOR CUSTOMER SERVICE, PLEASE CALL
800-211-7641
lar earned in additional gains keeps
on compounding until you take your
money out. I fund my 401(k) retire-
ment account and my IRA to the max,
and always recommend that you do
likewise. (And just last month, Dan
recommended you kick-start your kid’s
retirement with a tax-deferred Roth
IRA. So we’re both big believers in tax-
deferred investing.)
So what’s the catch? First, it can take
a long time for the benefits of tax defer-
ral to compensate annuity buyers for
the higher expenses annuities charge.
Even Vanguard concedes that “it may
take ten years or more for the benefit of
tax deferral to offset the costs associ-
ated with a variable annuity.”
Another wrinkle in the tax-defer-
ral story is how your withdrawals are
taxed. If you funded your annuity with
pre-tax dollars, then every dollar you
take out—whether it is from your prin-
cipal or profit earned through divi-
dends or capital gains—is considered
“income” to the tax man. If you funded
your annuity with after-tax dollars, only
the profits you withdraw are taxed—but
they are still taxed as income.
It’s all a matter of tax efficiency.
Take a look at the accompanying piece
on page 15 for a more in-depth review.
While your money grows more quickly
in a tax-deferred annuity, even under
favorable assumptions, by the time you
consider the higher expenses and the
tax consequences of paying income
versus capital gains taxes, you need to
hold an annuity for decades to make it
worthwhile.
Now, remember that death benefit I
mentioned? The language in most death
benefit provisions says that your benefi-
ciary is entitled to your annuity’s assets
on your death. Simple. But as with all
things related to annuities, the matter is
a bit more complicated. You only die
once, but Vanguard offers investors the
choice of two death benefits.
top, annuities have a “death benefit” to
protect your loved ones when you pass.
That all sounds great on paper, and
if variable annuities lived up to every
promotional claim, this wouldn’t even
be a conversation. But reality has a way
of tarnishing this image.
Let’s start with expenses. Broadly
speaking, annuity expenses are outland-
ish, with sales agents regularly earning
5% or more in fees. (This is one reason
some say that annuities are sold, not
bought.) Plus, their ongoing operating
expenses tend to be high—really high.
True to form, though, Vanguard’s annui-
ties are among the cheapest around. But
compared to a Vanguard mutual fund,
they are still astronomically priced.
One example: While good old
500
Index
currently charges 0.16% in oper-
ating expenses, the identical
Equity
Index Annuity
charges 0.44% at a
minimum. A few dozen basis points
isn’t usually worth getting too worked
up about, but that higher fee is going to
chip away at returns month after month,
and, well, it adds up over time. Over the
10 years ending in March, the annuity
has lagged 500 index by 30 basis points
per year, which translates into a total
return of 89.3% for the annuity versus
94.6% for the index fund.
In addition to those high fees, you
could be hit with a penalty for early
withdrawals should you need your
money sooner than expected. While
Vanguard’s annuities do not have
“withdrawal charges,” other annuities
do. And with all annuities, including
Vanguard’s, withdrawals made before
age 59.5 may be subject to an addi-
tional 10% federal penalty tax. No such
penalty exists with a regular mutual
fund, except for short-term redemption
fees, which typically only last from 30
to 90 days from purchase.
Even the issue of growing your
money in a tax-deferred manner isn’t
cut-and-dried when it comes to annui-
ties. I love tax-deferred investing.
Every dollar you invest and every dol-
ANNUITIES SOUND LIKE
a silver
bullet for retirement: Tax-deferred
growth and guaranteed income for life.
Everyone should have one, right? Well,
at this point in life, we’ve all learned
that if something sounds too good to be
true, it probably is. So let’s take a look
at what annuities are and are not—and
why Dan and I remain skeptics.
Annuities are insurance contracts,
and they come in many different forms.
Income annuities require that you hand
over a lump sum of cash to an insurance
company, and then that company pays
you regular income for the term of the
contract—usually life. Those payments
can start immediately or years down
the road. They can be fixed or tied to
inflation.
As with so many things, the devil
is in the details. When it comes to
annuities, well, it all depends on your
contract. A simple story told by an
annuity sales rep can quickly become
dizzyingly complicated. Vanguard no
longer offers its own income annuity,
but does provide a platform to compare
quotes from various insurance compa-
nies. What Vanguard continues to offer,
though, is another flavor of annuity—
deferred variable annuities. So let’s dig
in there.
Here’s how deferred variable annui-
ties are supposed to work. First off,
most investors will begin building a tax-
deferred portfolio by maxing out their
IRAs and 401(k)s or other retirement
or tax-deferred investment options. Of
course, there are limits to how much
you can put into these retirement port-
folios. But you aren’t limited in your
purchase of a variable annuity—you
can put in as much as you like. In some
situations, you can also add to the annu-
ity over time. You choose how your
money is invested, and your money
grows without the drag of taxes. Then,
in retirement, your annuity provides a
steady, and in some cases, guaranteed,
stream of income regardless of what
the market does. And as a cherry on
FUNDS FOCUS
Variable Annuities Don’t Match the Hype
>
SEE
FOCUS
PAGE 12